-19-
portfolio equity assets will deviate from the return on a ‘global’ stock market index to the
extent that a country pursues an idiosyncratic investment strategy for the foreign
component of its portfolio.
In addition, we consider the co-movement between the rate of return on foreign assets and
various domestic financial returns
rFA=αi+β*rikMt +νijt (7)
ijt i i t ijt
If β= 1 , holding foreign assets provides no diversification against fluctuations in
domestic financial returns. The weaker is the positive co-movement, the greater is the
scope for risk-sharing.22
Third, we consider the relations between domestic- and dollar-based ex-post real returns
and the real exchange rate. Go back to an approximation of the identity (4)
ritUS =rit + drerit (8)
where drerit is the rate of real appreciation vis-à-vis the US. If returns were entirely driven
by ‘domestic’ factors (orthogonal to exchange rate movements), the domestic real return
and the real exchange rate would be uncorrelated and real exchange rate movements
would fully pass through into dollar real returns. If instead returns were entirely driven by
‘external’ factors, the correlation between the dollar real return and the real exchange rate
would be zero and real exchange rate movements would fully pass through into domestic
real returns.23
22 If markets are not integrated, a low co-movement in returns may simply reflect the
absence of common pricing factors. We checked our results using only a shorter sample of
more recent data and the findings were broadly similar.
23 An interesting general question, which is outside the scope of this paper, is how real
exchange rate movements influence ex-post returns. (Of course, in terms of ex-ante
returns, expectations of real exchange rate movements will drive a wedge between
domestic and foreign returns but this link may be broken by ex-post shocks.) The relation
depends on whether returns on assets/liabilities are primarily based on domestic or
(continued)